The magnificent 7 and equity markets - Review 11

Since I last wrote about the magnificent 7 in February 2011, a lot has happened and it is rather appropriate to review where do we stand at the beginning of 2012.

Despite all discussions about recession/double dip in the US for most of 2011, it did not occur and growth looks to carry on, whilst at a moderate pace; this is strikingly different from what we have been witnessing in Europe since the summer and the inability of European policy makers to put the eurozone (“EZ”) house in order.

In 2011, the DJ increased 5.5% (the S&P 500 was flat) which is not so bad given what happened in the world, and in Europe in particular. If one picked up dividend aristocrats it was a reasonable year in the US.

 In Februray 2011 I wrote: “Economic news from the US continue to point towards a continued GDP growth and a (slowly) improving situation in unemployment; Commercial and Industrial Loans at All Commercial Banks in the US have definitely passed the trough and now seems to be well entrenched in an upward move”.  . The latter indicator has displayed the 12^th positive number in a row for a total of USD +114 bn (USD -411 bn during the 25 months starting in November 2008) and this points towards a continued growth in the US 6 months ahead.

Friday’s employment numbers were rather positive at +200k bringing the unemployment rate down to 8.5%.

Things indeed went in the right direction and 2012 starts under the same auspice bearing that:

• The FED continues with its low interest rate policy along the yield curve, which is most likely during a Presidential election year and in the current economic environment.
• International investors continue to buy the US debt, which they should in my opinion by the lack of other choice, continuing to believe that the US will tackle one for all its deficit and inflation will be kept in check. 

In Europe, the picture is getting worse by the month, even the German engine is slowing down markedly. There are more and more voices calling for custom tariffs to fend off imports from low costs producing countries and added regulation: Europe has been naïve with its strong euro policy (well, it was Germany’s call to get the euro) and is battling the last war with increasing regulation, taxation and bureaucracy. Until the EZ sorts out its mess (both banks and over indebted countries) growth will be sub-par. This being said, like in the US, there are world class companies, which are more affected by what happens in the fast developing world, and very profitable niche players that we like to find at P&C.

Fast growing economies in the rest of the world keeps up forging ahead whilst inflation continues to be a real issue (food prices remain very high in China and India, albeit going down recently). However, this is more a consequence of a growing population and a faster developing middle class: a strong engine to growth. In addition, some countries like India are going 2 steps forward and one backwards in terms of liberalization of their markets (for example opening up the country to foreign supermarket companies). 

The graph below is self-explaining…

S&P 500 Banks index: for over two years, the index has traded range bound and has yet to decisively to breach the 165 level; there is no sign this happening any time soon and, conversely, there is no sign of a deterioration either, US banks continuing to recapitalize thanks to an unabated FED QE. In my opinion, the level comes from a continuing reappraisal of the future profitability of banks (less leverage + more controls = lower ROE) versus their ability to pass on additional costs to customers. Neutral.

Global 1200 financial index: The index broke its 200 MA in May 2011 and several support levels, reflecting the deepening crisis in the EZ and the need to recapitalize European banks beyond the official numbers (not talking about OTC derivatives where nobody knows what the global risk is, even banks on an individual basis probably do not know their real risk); the solid 800 floor was penetrated without a whisper and now represents a resistance. The outlook for a number of Europeans banks is bleak and the introduction of Basle III rules ahead of the 2019 deadline is adding pressure. Negative.

TED spread (LIBOR USD 3 mth - US 3 mth T-bills): since July, the spread has deteriorated but in an orderly manner (the OIS displays the same pattern) and is nowhere near the 2008 crisis levels, with central banks reacting very quickly by opening USD swap lines and the ECB offering 3 years lines of credit (LTRO) in the tune of EUR 426 bn. Neutral

USD bank BBB 10 yr - US 10 yr yield: In July the spread started to widen markedly, whilst well below the extraordinary stress of 2008-2009, to pause for the past 2 months. Neutral.

OEX volatility: OEX volatility had a spike during the summer but did not break the high of 2010 and has since come back to the low 20s. Positive.

S&P Case Shiller house price index: The latest data for US home values (October) published 27^th December have continued to go down for the 5^th consecutive month, only two cities showing positive numbers.

The unadjusted data are negative (-4% since July, the recent high); adjusted data display the same pattern:

Composite-10: Oct 2011: m/m -1.1%; y/y -3.0%

Composite-20: Oct 2011: m/m -1.2%; y/y -3.4%

As the report comments:

“Some of the other housing statistics posted relatively healthy figures for November, but it seems that most of the good news was confined to the multi-family sector. Existing home sales rose in November, but are still at a low annual rate of about 4.0 million. Single family housing starts also rose, but remain close to record lows and are still down about 1.5% versus October 2010.”

The recovery did not materialize. Negative.

Oil price: The WTI oil reached a peak of $115 to settle down in a $80 - $110 range. In 2011, the story was he spread between the WTI and Brent which reached $25 in August reflecting the glut of crude at refineries in the US and the Arab world revolutions with oil disruptions in Libya. In the US, unconventional oil & gas recovery is a game changer which explains low prices for natural gas at below $4/btu: Neutral.

Conclusion: The indicators on the banking situation deteriorated, whilst other indicators are mostly neutral. The macro-economic situation between Europe and the US is diverging to the advantage of the latter, even if in both cases public finances are in disarray. The magnificent 7 are telling us that nibbling equity markets will provide an interesting return.

2011 was bumpy and 2012 will be no less hectic.

Continue investing in high yielding equities / net cash companies with a strong franchise and look at strong brands in fast growing economies.

09/01/2011

 

Sources:

Markets & Beyond: The magnificent 7 and equity markets - Review 10

http://marketsandbeyond.blogspot.com/2011/02/magnificent-7-and-equity-markets-review.html

US Department of the Treasury: Monitoring the economy

http://www.treasury.gov/resource-center/data-chart-center/monitoring-the-economy/Documents/monthly%20ECONOMIC%20DATA%20TABLES.pdf

S&P/Case-Shiller Home Price Indices

http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldocumentfile&blobtable=SPComSecureDocument&blobheadervalue2=inline%3B+filename%3Ddownload.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-type&blobwhere=1245326665736&blobheadervalue3=abinary%3B+charset%3DUTF-8&blobnocache=true

Markit (via Business Insiders): Manufacturing PMI indices by country

http://www.businessinsider.com/chart-of-the-day-manufacturing-pmis-january-2011-vs-december-2011-2012-1?nr_email_referer=1&utm_source=Triggermail&utm_medium=email&utm_term=Money%20Game%20Chart%20Of%20The%20Day&utm_campaign=Moneygame_COTD_010312

A week in Europe – 20 years after the Maastricht Treaty

Last week’s Brussels’ summit delivered what has been hailed in most media and the usual politician consensus as being THE grand plan that will save, the euro and Europe, nothing less. Let’s reviews what was announced:

• A new concept of fiscal rule (“fiscal compact”) is introduced whereby the budget deficit cannot exceed 0.5% of GDP and this rule will be enshrined in national constitutions. An automatic correction mechanism will be triggered if the ratio is deviating from this level.
• Sanctions will be automatic when a country breaches the Maastricht Treaty criteria of fiscal discipline (maximum 3% GDP/budget deficit and 60% debt/GDP), but for a qualified majority of EZ members, and will be monitored by the Commission and the Council.
• The private sector (read banks and insurance companies) will no longer participate in the cost of bailing out European countries beyond Greece.
• The ESM will be brought forward to July 2012 and in case of emergency a qualified majority is set at 85% (subject to Finland Parliament approval). Together with the EFSF, it will amount to EUR 500 bn to be reviewed in March 2012.
• Up to EUR 200 bn will be provided by EU members to the IMF via bi-lateral loans to reinforce its intervention means (to be confirmed within 10 days of this agreement), including EUR 1500 bn from EZ countries.

This plan, like all the other ones designed over the past 19 months, will fail:

• The text, like the previous ones, contains a lot of waffle: many words but nothing immediately concrete whilst the liquidity crisis is hurting right now and the solvency one is round the corner, all final decisions and details being pushed back to March 2012. The objective was once more to kick the can down the road…
• The fiscal compact falls short of a true fiscal integration. And without it, the ECB (the Bundesbank) will not finance European sovereign debt until the very last minute if any, i.e. when the cost will be horrendous for European citizens.
• Rules are tightened to curb future debt but nothing is done to resolve the current insolvency of banks and over-indebted countries. The crisis is now, not next year or in two years time.
• EUR 500 bn is nowhere near what is required: EUR 1-2 tr (Euro-area governments have to refinance more than EUR 1.1 tr of debt in 2012 plus aprox 300 bn of new debt without the potential bailout of a few banks).
• The private financial sector is lo longer accountable for its mistakes increasing moral hazard.
• There is no guarantee that the sanctions to be imposed on deficit countries will have any effect since they know that it is doubtful the would be thrown out of the EZ (otherwise Greece should have been kicked out over a long time ago); the only efficient threat of sanction is for countries to loose their voting and vetoing powers with the EU institutions and put such countries under tutelage. Politicians do not care about other (financial) sanctions.

The three main roots of the crisis are not addressed:

• Unbalanced financing of sovereign debt deficit: The EU does not lack savings but Northern investors are rightly reluctant to finance Southern Europe. Domestic retail investors should be called upon with attractive enough terms.
• Unbalanced trade: the competitive north increases its competitiveness vis-à-vis the south which has a growth model based on consumption, which is not viable long term and showed its limits.
• Lack of growth, itself a result of the absence of fundamental social and economic reforms in Southern Europe.

The ECB is the only institution with the means to backstop European sovereign debt and provide unlimited liquidity to banks. This must be accompanied by deep structural reforms including pushing back the age of retirement (at least 65 years and probably beyond if no sharp improvement in the fecundity rate of Europeans), lengthening the weekly working hours to at least 40h and probably 42h without a commensurate salary increase and drastically reducing the functioning cost of government and local authorities by reducing the number of civil servants or their salaries (its increase rate should be limited to a maximum of 50% of the GDP growth rate).

The alternative is debt restructuring or outright default.

As it stands today, the grand plan lacks credibility.

Markets also seem very skeptical…

Source:

European Council: Statement by the Euro area Heads of State or Government

http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/126658.pdf

European Commission: Economic Governance in graphs

http://ec.europa.eu/europe2020/priorities/economic-governance/graph/index_en.htm

Bloomberg: Euro Leaders Push Budget Rigor 20 Years After Maastricht With Onus on ECB

http://www.bloomberg.com/news/2011-12-09/euro-states-to-shift-267-billion-to-imf-as-focus-shifts-to-deficit-deal.html

European rescue package: truth and fallacy

It occurred to me that the EUR100 bn private sector participation to the latest Greek rescue might no be as large as trumpeted by European leaders on 27^th October. 

The statement:

“…we invite Greece, private investors and all parties concerned to develop a voluntary bond exchange with a nominal discount of 50% on notional Greek debt held by private investors.”

The facts:

1. Greek’s sovereign debt holders split:
 

• Commercial banks: EUR81 bn
• ECB: EUR45 bn
• EU/IMF: EUR65 bn
• Others (SWFs, asset managers, central banks, public sector funds): EUR159 bn

2. As per EBA data published in July stress test, Greek banks shared 59% of the total held by commercial banks, i.e. EUR48 bn. The reduction in Greek debt will be at least partly compensated by a bank recapitalization (I estimate it at around EUR30 bn – same as the EBA): the net effect on the Geek sovereign debt reduction is therefore rather minimal at approximately EUR18 bn (assuming that Greece and not the EFSF recapitalizes). 

3. According to a research published by Barclay’s Bank in July, EUR11.3 bn are held by EZ Insurance companies: 50% is EUR5.7 bn.
 

4. Non-Greek European banks will take a EUR16.5 bn loss.

5. Remains private assets managers and smaller holders of Greek bonds which I believe are not significant: say EUR 30bn to be generous or a EUR15 bn loss.

The total losses realized by the private sector would therefore amount to EUR55 bn, far from the EUR100 bn trumpeted.

Conclusion

If non-Greek European private sector banks would write-down +/- EUR16.5 bn, one may wonder why the EBA requires them to raise EUR76 bn whilst they are profitable enough (but for a few exceptions) to absorb losses on Greece and reach the 9.5% Basle III capital requirements.

Because, there is more to come; then EUR106 bn will not be enough; watch non-performing private sector loans in Greece and elsewhere as well as Italy, France, Portugal, Belgium, etc. sovereign debt… Italy’s interest rates on its debt are close to unsustainable at 6.6% and France together with Belgium are rapidly going the same way: any 1% increase translates into +/- EUR19 bn additional interest payment in a full year for Italy and EUR17 bn for France.

The EUR1 tr EFSF will not be enough, nor the EUR200 bn recapitalization recommended by the IMF: but for a euro split/collapse, the only remaining solution would be for the ECB to monetize sovereign debt for BIGSPIF. Germany has already started to eat its hat; when enough will be enough for Germans?…

BIGSPIF: Belgium, Ireland, Greece, Spain, Portugal, Italy, France 

07 November 2011

Source:

European Banking Authority: The EBA details the EU measures to restore confidence in the banking sector

http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx

The Institute of International Finance: Press Statement on Euro Area Stablization Measures

http://www.iif.com/

European Commission: Euro Summit Statement

http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/125644.pdf

Eurozone as we have known it: end of story

1. Greece

Tuesday’s announcement by the Greek Prime Minister, Giorgios Papandreou, of an impeding referendum on the second rescue package concluded a few days before sent market rolling and policy makers tangling in despair and frustration.

It was doubtful that this rescue package would work, but at least it was buying (wasting) a bit more time.

Interesting enough Wednesday’s evening discussion between Merkel, Sarkozy and Papandreou ended up for the first by mentioning the exit of euro for Greece if Greeks vote no to the rescue package, which so far was dumb impossible… As I wrote to JC Juncker in July, Europe lacks credibility and its first task should be to reinstate it: For 2 years, the opposite way has been followed by a succession of denials and scapegoating.

If I were Greek, I would go straight away to my bank and get all my cash to hide it under the mattress; so, expect a run on Greek banks that are bankrupted anyway with their load of junk Greek sovereign debt.

November-December 2011 debt redemption schedule:

11 November: EUR 2 bn (26 wk T bills) + 49 mio interest

18 November: EUR 1.6 bn (13 wk T bills) + 18 mio interest

12 December: EUR 2 bn (26 wk T bills) + 50 mio interest

23 December: EUR 2 bn (13 wk T bills) + 46 mio interest

According to Papandreou, Greece has enough money to survive until mi-December, so just after the referendum due to take place 4^th December.

Well, if there is a referendum (there are rumors it would be called off; what a farce!!): Papandreou called a vote of confidence for Friday; if he does not win then new elections would be called and the referendum becomes history. The EU and IMF would provide Greece with its EUR 8 bn 6^th tranche from the first EUR 110 bn rescue package.
Alternatively a Government of national union could be formed with the opposition. This would be the best outcome for the EZ and the euro.

2. Italy

Friday’s bond auction witnessed an interest rate increase to 6% (so before Papandreou referendum announcement) and since, borrowing costs have reached a record high (10 year bonds reached a high of 6.399% today), not seen before the creation of the euro. The cost of debt is not sustainable.

Wednesday evening Berlusconi could not get cabinet approval when his Northern League ally refused to increase the retirement age from 65 to 67 years as demanded by Merkel-Sarkozy for the G20 meeting in Cannes, which castes doubts about Italy’s ability to implement unpopular measure to reduce its (slowly) mounting debt.

Whilst Italy’s economic situation is on many indicator much less worse than France’s, its weak political system, large legacy debt and slow growth are making the country the target of markets.

France is however not far behind.

3. France

On many indicators, France is in a worse situation of Italy: debt increase (will soon catch up Italy), primary budget deficit, trade balance and unemployment.

The 2012 budget is based on a 1.75% real GDP growth that will not be reached: the consensus stands at 0.9%. This means finding EUR8-9 bn to maintain the objective of deficit reduction down to 4.7% in 2012 and 3% in 2013. However, most of the rumored measures are in the form of tax increase and not economies. Yet with the previous EUR11 bn deficit reduction announced a few weeks ago, EUR1 bn was made of cost cutting whilst EUR10 bn were tax increases. France has always the tendency to increase taxes instead of reining in it overload civil service (in particular with local authorities which has boomed for the past 10-15 years).

Markets are taking notice and spreads with Bunds have trebled since early July:

France is next in line (together with Belgium) and is at risk of loosing (should loose) it AAA rating which is the cornerstone of the EFSF together with Germany’s AAA. Any downgrade will pressure rates at which the EFSF borrows ; yet, Wednesday, the EFSF had to postpone a EUR3 bn bond issue schedule in the next fortnight and 10 yr spread over German Bunds increased to 1.5% from 0.7% in September.

The current crisis exemplified, if needed to be convinced, that the construction of the EU and EZ is a Franco-German affair. Whilst Germany is clearly in the driving seat (in the end who gets the money decides), there still is an appearance of equality between the two countries: would France loose its AAA, this balance would be shattered and Germany could, politely, pursue its own interest, eastwards…

Conclusion

France is the hidden weak link of core EZ and this begins to appear openly. I very much doubt that France will be able to abide by its budget deficit forecast without number muddling (France can always call on the CDC – a large French state-owned financial institution- to get a couple of billions euros).

After this crisis, the EZ cannot be the same: the way it works, decisions taken, budgets voted, Maastricht criteria respected (or even more stringent ones: no budget deficit), money spent, will make the EZ, if it survives, a different planet. Even its perimeter can be challenged. I still believe that a narrower EZ with a euro DM is a possible outcome: the question is, would France be part of it?
Anyway, Europe will be German or will not be.
03 Novemberg 2011

Source:

Bloomberg: Europe’s Financial Crisis Deepens as Greek Government Teeters

http://www.bloomberg.com/news/2011-11-03/europe-s-financial-crisis-dominates-g-20-talks-as-greek-government-teeters.html

Bloomberg: Berlusconi Arrives at G-20 ‘Empty-Handed’ After Vowing Economic Overhaul

http://www.bloomberg.com/news/2011-11-03/berlusconi-arrives-at-g-20-empty-handed-after-vowing-revamp.html

Financial Times: EFSF postpones €3bn bond issue

http://www.ft.com/cms/s/0/47f3998e-0546-11e1-a3d1-00144feabdc0.html#axzz1cdb7yxNB

Euro summit: kicking the can down the road once more

1. The agreement

As for a well written movie script, the 4 am press conference concluded weeks of discussions, haggling and wrangling about this Greek drama. Like the other 10 or so summits about the eurozone crisis, this is meant to be the final shock and awe response to years of denial, the ground-breaking decisions.

The agreement can be summarized as follows:

• Nominal write-down of 50% (EUR 100bn) of Greek debt in private hands; Greek debt owned by official lenders not touched (so the ECB will not need to be recapitalized)
• Remaining Greek debt will be refinanced at preferential rates
• Bond swap to be done by end-January 2012
• Closer supervision of Greek adherence to the program
• EFSF to be levered 4-5 times
• No ECB involvement in EFSF 
• President Sarkozy will speak with China on EFSF
• EFSF will have both a direct insurance and SPV element; looking for EM/IMF support for the SPV
• Estimates of EFSF firepower ranged from EUR1.0-1.4 tn
• Italy to deliver specific budget 
• Banks will raise EUR 106 billion of Core Tier 1 capital by the end of 2012 to reach a 9% capital ratio (plus an additional EUR40 bn capital buffer).

Thursday, market reaction was enthusiastic with bank stocks gaining double digit (Crédit Agricole up 23%!) and the EUR jumping 2% vs. the USD. This looks however more like a relief of not being dead than anything really of substance so far since there is a lack of detail and a lack of surprise. Today’s (Friday) Italian bonds yields are reaching 6% again and French bond spreads to Bund are widening close to 1%.

Finance Ministers will decide details in November: as always the devil is in the details.

2. Analysis

• The 50% haircut the private sector will “voluntary” write-down represents EUR 100 bn (EUR350 bn - EUR70 bn Troika loans - EUR75 bn held by the ECB)*50%: this pushes the debt/GDP ratio down to 120%.
• The press release indicates: “…with an objective of reaching 120% [the debt/GDP ratio] in 2020”. So, if I correctly read this section of the press release and based on September IMF numbers, it means that the Greek situation will not improve for the 10 coming years or so at double the Maastricht Treaty criteria and back to where the ratio was in 2009. In addition, I doubt that structural reforms, if really implemented, will produce results before years to come and a GDP decline is to be expected for the next 1-3 years in the absence of currency devaluation.
• Finally, according to IMF projections, and nothing beyond the EUR 100 bn forgiveness has changed, the debt/GDP would reach 143% in 2012.
• Investors could question the quality of the EFSF guarantees (which only apply in case of default) since the ISDA declared that the 50% haircut being “voluntarily” gun-to-my-head does not constitute a credit event therefore a default. The same thinking could apply in the future to the guarantees provided by the EFSF on bond purchased from Greece (or other Eurozone countries). In addition:

• Since it is meant to be voluntary, some could choose not to exchange their current holdings for new bonds weakening this frail restructuring if numerous enough
• No detail on how it would be structured: maturity of new bonds, interest rate, guarantees if any, ruling law, to name a few
• Other EZ countries could give up and ask part of their debt to be forgiven

     Despite the EUR100 bn debt default, this is not going to have much impact on the Greek budget: for over a year, Greece has not borrowed on capital markets but with the Troika and short term T bills at c. 5% and not at secondary market rates of 20%+.

Saving: EUR106 bn*5% = EUR5 bn i.e. +/- 25 % of current interest payments or 2% of GDP.

This will leave the country with a negative primary budget running at about EUR1.5 bn/month or 30% of state’s revenues.

• All this is gaining some time, but does not address the issue of the lack of state cash flows generated by the absence of growth, a weak central state and a large black as well as uncompetitive economy.
• EUR106 bn of new core capital will not be enough if other Latin European sovereign debt is marked-to-markets (just think Italy).

All this edifice also assumes no AAA downgrade for France, which I do not believe: France does not deserve a AAA rating.

Conclusion

This week’s measures bring some short-term relief but are far from being the shock and awe required and is short in details: European leaders once again kicked the can down the road, farther this time, I admit.

The winner is China that will have a strong hand with Europe while protecting its largest market from collapse as well as its EUR 600 bn of European debt.

As a side comment, European leader were prompt (and rightly) to name and shame leverage as the culprit of the financial crisis and are doing the same with the EFSF.

Source:

European Union: Euro summit statement

http://consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/125644.pdf

European Banking Authority: Capital buffers for addressingmarket concerns over sovereign exposures

http://www.eba.europa.eu/cebs/media/aboutus/News%20and%20Communications/Sovereign-capital-shortfall_Methodology-FINAL.pdf

European BankingAuthority: The EBA details the EU measures to restore confidence in the bankingsector

http://www.eba.europa.eu/News--Communications/Year/2011/The-EBA-details-the-EU-measures-to-restore-confide.aspx

European banks’ recapitalization

When the EBA stress tests on 90 European banks were published in July, I titled them a mockery. I conducted my own analysis according to a 50% and 75% haircut on sovereign debt in PIIGS countries to abide by the 9.5% core capital to be reached by 2019 according to Basle III rules (many banks said they would get there well ahead of time): this analysis produced the numbers I mentioned in several articles on this blog.

In the table below, let’s look at German and French banks’ exposure to the Greek sovereign debt (being the main holders, I do not include other banks):

A 50-75% Greek default would result EUR 36 and 40 billion new capital required, split 1/3 for Germany and 2/3 for France. This does neither take into account their exposure to the banking and private sector nor guarantees/commitments/derivatives (including CDS). The German situation is not much worse with respectively EUR 9.7 billion additional exposure (including EUR 2.1 billion with Greek banks) and EUR 5.3 billion; French banks’ are in a much more difficult position with EUR 43.5 billion (including EUR 1.6 billion for banks) and EUR 8.3 billion.
To be fair, these numbers reflect the situation at the end of December 2010 and French banks have significantly reduced their exposure on their Greek sovereign debt during H1 2011: BNP Paribas from EUR 5 billion to EUR 3.5 billion and Société Générale from EUR 2.7 to EUR 1.9 whilst producing a net 6 months result of EUR 4.7 billion and EUR 1.6 billion, so enough to absorb a 100% default. However, as for Dexia that went under mainly because of its exposure to the non-sovereign credit book, I do not know what the quality of the private book is.

Let’s add a 100% default on Greek banks and 15 % on the private sector (guarantees and commitments included but not derivatives), the banking needs required to abide by Basle III rules is north of EUR 50 billion for German and French banks that were subject to the EBA stress test.

The total number of EUR 100 billion rumored to be in the starting blocks to recapitalize European banks is probably right on a Greek basis alone. In order to weigh the minimum possible on government budgets already under dramatic strain, this recapitalization should be undertaken via profits, cutting dividends to zero and reducing bonus payments (say by the same amount as the Greek default). It is however far from addressing the rest of BIGSPIF sovereign risk.

Nevertheless, the EUR 100 capitalization does not address the core of the matter: the sovereign insolvency and lack of economic competitiveness. More on this in a forthcoming article: France - EZ weak link.

BIGSPIF = Belgium, Ireland, Greece, Spain, Portugal, Italy, France

Who should be single A rated: Italy or France?

I am amazed that France rating has not been downgraded as yet: it does not deserve a AAA by a long margin.

First, have a look at current rating for European countries (please note that since this table was published, Moody’s downgraded Italy 3 notch to A2 from Aa2, i.e. the same as Poland or Cyprus). This downgrade is probably justified in itself, but I am questioning how France can retain the top rating.

From data published by the OECD in May and the IMF in September, France is in a worse shape than Italy according to many indicators.

1. Debt/GDP

If the debt/GDP is the Achilles heel to Italy, its growth is nowhere comparable to France’s which is catching up quickly: +6% for Italy for the period 2000-2012 and +52% for France.

2. Real DGP growth

France is much better off with GDP growth twice the pace of Italy during 2000-2012 at 1.5%. French growth is however mainly due to domestic consumption spurred by the state welfare that France can no longer afford.

3. General Government Financial Balances

The French welfare state largess translated into higher budget deficits whatever the Government (France hasn’t had any balanced budget since 1978): the Maastricht 3% deficit ceiling was respected only 4 times since 2000, France doing much worse than the eurozone average since 2008 (-5.9% vs. -4.6%); - Italy fared better with -4.1%.

Analyzing further the budget, the situation looks even much worse for France: its primary budget balance has been negative for 10 years whilst Italy had always been positive (note that Italy’s primary budget is even much better than Germany). The IMF does not expect France’s primary budget to become positive before 2015.

4. Trade balance (goods & services)

This indicator is not helping out France’s precarious position, to the contrary. Since 2005 France has experienced increasing trade deficits, together with Italy but with an incomparable magnitude: USD 489 billion cumulated, 2.3 times more than Italy; Germany in the meantime accumulated a USD 1550 billion surplus. In percentage of GDP the analysis is the same.

True France enjoys a net investment income whilst Italy is negative, which translates into a comparably better current account for France.

5. Unemployment rate

Unemployment is another indicator where France is not comparing well with Italy, underperforming since 2003.

Conclusion

France does not deserve the top rating with the three main rating agencies (by the way, when European politicians accuse these agencies of an American plot against Europe, beyond being a “scapegoating” affirmation, they should remember that Fitch belongs to a French company, Fimalat).
According to the indicators presented, France should hardly be better rated than Italy.

Add guarantees to be given by France for Dexia’s failure (where France should bear most of the burden since most of the problem arises from Dexia CLF - the French part of the group with 259 x leverage!) and I do not see how and why France will keep its AAA. Belgium is under watch for possible downgrade following Dexia’s bankruptcy. It is also quite “funny” to watch France arm twisting Belgium to bear most of the burden in order to keep its AAA (that it will loose anyway): how guarantees for the EUR 95 billion impaired portfolio will be shared (EUR 66 billion in Dexia CLF balance sheet)…

The “funniest” of all is that Dexia CLF is going back to CDC (the French state owned financing vehicule) where it originally came from under the name of CAECL. From privatization to nationalization, 20 year of incompetent board of directors that let an incompetent management expand all around the world into risky businesses without the means (read capital) of their ambitions.

Please note that I do not blame the new management that arrived after the 2008 rescue since Dexia was doomed: there was not much they could do, and they probably did what they could with the legacy they got.

Source:

WSJ: S&P Cuts Italy's Sovereign-Debt Rating

http://online.wsj.com/article/SB10001424053111904106704576581301721363640.html

IMF: World Economic and Financial Surveys

http://www.imf.org/external/pubs/ft/fm/2011/02/pdf/fm1102.pdf

© Markets & Beyond

OECD: OECD Economic Outlook No. 89

http://www.oecd.org/document/61/0,3746,en_2649_34573_2483901_1_1_1_1,00&&en-USS_01DBC.html

Markets & Beyond: Dexia in 2 slides and a few words

http://marketsandbeyond.blogspot.com/2011/10/dexia-in-2-slides-and-few-words.html

Dexia in 2 slides and a few words

I warned about Dexia weeks ago, and during private discussions over the summer I discussed with a top official in Luxembourg about its demise and breakdown.

Leverage core equity / total assets: 75 x! (36x if using the Basle II Tier 1 capital definition): so, doomed in a recessionary environment where nearly 50% of loans are with local authorities that have difficulties to balance their budgets.

The French part of Dexia (formerly Crédit Local de France) is where most the group mess is coming from: the same ratio is much worse at 259 x!!! Even LTCM was not leveraged like this…

Dexia BIL (Luxembourg) is rather sound with a ratio of 18 x and its exposure to PIIGS (EUR 5 billion including EUR 536 million of sovereign debt) is manageable. DEXIA BIL will be bought by a bank like ING. I guess that Dexia BIL “legacy portfolio” (EUR 10 billion) will be consolidated with the other ones of the group into a bad bank.

Prima facie, the consolidated “legacy portfolio” does not look so bad: “only” EUR 7.7 billion non-investment grade; well, (1) what is investment grade today may rapidly become sub- investment grade tomorrow (see Greece) and (2) the EUR 4.1 billion allocated capital to the “legacy division” is not sufficient to match a 30% loss on the NIG loans.

In 2Q11, Dexia’s portfolio was reduced by EUR 6.8 billion vs. end of March 2011 with a loss of EUR 4 billion, i.e. ~60% mark-down.

Greece was provisioned for 21% (the IFF* agreement); the final loss will be between 50% and 75%, somore losses to come.

Short-term Funding need down EUR 47 bn which can only be funded with central banks, since I guess that Dexia is shut down from the interbank market.

This is a remake of the Irish banks: Dexia successfully passed the 2011 EBA test which was meant to be much more stringent: a joke I wrote in July.

* Institute of International Finance: the international professional organisation of banks

Conclusion

After Irish banks last year, Dexia situation exemplify the inadequacy of EBA tests which were politically motivated. For 3 years, the policy of denial followed by policy makers regarding Greece default and banks recapitalization has spurred volatility in markets: investors are reacting to hard facts and hate uncertainty and lack of action. Markets do not want words but acts.

It also shows how the poor quality of blinded European politicians made a limited disease become metastatic.

Continue to stay clear of European financial stocks (if you are a long term investor, there is better value elsewhere – if you are a trader volatility is always good): with Basle III and other rules, the finance industry will deliver lower long term returns on equity as written on this blog for 2 years.

Source:

Dexia Group: semi-annual report June 2011

http://www.dexia.com/EN/shareholder_investor/results/Documents/20110408_financial_report_2Q_UK.pdf

Dexia CLF: Rapport financier semestriel au 31 juin 2011

http://public-dexia-clf.dexwired.net/DCL/informations-juridiques-financieres/Documents/semestriel-dcl-2011.pdf

Dexia BIL : Rapport semi-annuel au 30 juin 2011

https://www.dexia-bil.lu/fr/Documents/resultats-financiers/rapport-semi-annuel-dexial-2011.pdf

Greece: this is THE week

As reporter by Bloomberg: “European Union and International Monetary Fund inspectors hold a teleconference call today with Finance Minister Evangelos Venizelos, to judge whether the government is eligible for its next aid payment due next month and on track for a second rescue package approved by EU leaders July 21.”

So, here we are, finally, decision have to be taken after months of wrangling, (badly) communicating and ignoring reality.

To raise EUR 78 billion in 5 years, Greece is to bring additional taxes, including a property levy for EUR 2 billion: I am wondering how the Government intends to implement the measure since the new land registry is not yet finalized and how will they be able to privatize without a certainty regarding title of assets (real estate is part of the EUR 50 billion privatization program); the initial deadline was November 21 and December 30 2008 depending whether your are Greek resident or non-resident, then postponed to H1 2010, and now October 31, 2011. The fun is that Greece first launched a project to record the use and ownership of land in 1995, with EU subsidies, but it ran into repeated delays and nobody at EU did react… When the blind leads the blinds…
As reported by the English speaking Greek newspaper Ekathimerini: “Greece hopes to complete the registration of all its land by 2020. So far, 13.8 million titles have been recorded on the cadastre.” 2020!

Ekathimerini is an endless source of information on Greece dysfunctions: “The Citizens’ Protection Ministry Tuesday rebuffed a report in the Financial Times indicating that Greece may be temporarily ejected from the passport-free Schengen travel area for its failure to keep undocumented immigrants out of the bloc […] It added [the Greek Citizens’ Protection Ministry report] that the Commission should support member states “managing the massive burden” of guarding the bloc’s external borders from illegal immigration.” Oh, yes, give me more money!

Do you want more? Yes? Let’s carry on:

“Whereas more than 1,000 Greeks were losing their jobs in the private sector every day in August, the government was assuring civil servants with lifetime tenure that their job privileges were not in danger and the so-called reserve pool was not intended for them but only for employees in the greater public sector. […] In the meantime, many Greeks were surprised to hear the government had hired between 15,000 and 20,000 people in the public sector in various forms since the start of 2010.”

About the need to reduce expenditures: “…closing down one or two money-losing state entities, such as the the Hellenic Railways Organization (OSE)…”

This is a topical and typical subject: the Hellenic Railways. A few numbers tell you all; for 2009 consolidated accounts:

Turnover - EUR 174 million

Operating loss - EUR 359 million

Total loss – EUR 937 million

Accumulated losses – EUR 2.5 billion

LT debt EUR - 7.8 billion

Interest paid - EUR 388 million (2x the turnover!)

Employees’ compensation - EUR 291 million (more than the turnover)

The auditors commented that they could not conduct a tangible asset and inventories impairment test as well as updating the fair value of investment real estate assets.

I could not find the same information for 2010. According to data released by the Ministry of Finance, on a non-consolidated basis, for the 5 months to May 2011, the situation has improved but remained catastrophic, the turnover is 3x less than personnel expenses (EUR 40,000 / employee / year as an average i.e. 4x the minimum wage, quite nice, and excluding various benefits – EUR 48,000 in 2010), the net loss amounting to EUR 164 million.

As a whole, during the same period, public entities had revenues of EUR 512 million personal costs of EUR 399 million and losses of EUR 534 millions (more than revenues). This tells you all, and the situation is “better” than in 2010…

Greece’s officials are willing to raise taxes and cash via privatizations; good luck! For example privatizations raised EUR 400 millions whilst EUR 5 billion was planned for 2011 – 3 months left…

However, I have no doubt that Greece will get its EUR 8 billion early next month.

Hopeless.

Source:

Ekathimerini: Investors sought for land registry

http://www.ekathimerini.com/4dcgi/_w_articles_wsite1_1_07/07/2011_397548

Ekathimerini: Land register invites private bids

http://www.ekathimerini.com/4dcgi/_w_articles_wsite1_1_04/08/2011_401150

Ekathimerini: Ministry rebuffs Schengen report

http://www.ekathimerini.com/4dcgi/_w_articles_wsite1_1_13/09/2011_406189

Ekathimerini: Civil servants in the firing line

http://www.ekathimerini.com/4dcgi/_w_articles_wsite2_1_18/09/2011_406931

Ministry of Finance:

http://www.minfin.gr/content-api/f/binaryChannel/minfin/datastore/bf/75/78/bf7578dec0e469420b8d6f742d5815d182d31eee/application/pdf/5-month+period+2011+comments+ENG.pdf

Hellenic Railways Organization: Annual financial statements for 2009

http://www.ose.gr/LinkClick.aspx?fileticket=eVoOiPOHPnY%3d&tabid=541